Concerns over the financial health of Iceland’s aviation giant, WOW Air, have fueled countrywide speculation about the outcome if the company were to face further headwinds. Rumours have already lowered consumer confidence, leading to 2% depreciation in the Icelandic króna in a single day.

“Tourism is the largest export sector [in Iceland] by far,” Arion Bank’s report on the growth potential in the tourism industry begins, “It is extremely rare for tourism to be such a determining factor for an economy.”

Local Currency Volatility Stemming from Anxiety in the Market

In the past month, the Icelandic króna, which is notably volatile, took a 6% dip against the Euro, 2% of which occurred on Sept. 11, 2018. The drop was a result of market frenzy over the credit health of Icelandic budget airline WOW Air, which carried approximately 28% of passengers to Iceland in 2017.

Because the currency depreciation unfolded rapidly, the Central Bank of Iceland chose to intervene in order to prevent a further drop—meaning that it boosted demand for the króna, shoring it up against excessive fluctuations in the exchange rate. That measure is in place in the event of abrupt depreciation, and the Central Bank’s current account surplus, though declining, is sufficient to deal with unexpected adverse events in the market (0.6% of GDP).

“The depreciation has been somewhat faster than most had expected […] and now the nominal exchange rate is similar to August 2016,” said Erna Björg Sverrisdóttir, a researcher at Arion Banki, one of Iceland’s three major banks.

WOW Air’s Financial Prospects Play an Essential Role

The instability stems from uncertainty around WOW Air’s financial prospects; the airline, which saw an ISK2.4 billion ($211.5 million/€182 million) loss last year, is currently in discussions with investors to issue up to ISK12 billion ($113 million/€96 million) in three-year convertible bonds. Earlier this year, WOW Air CEO Skúli Mogensen made a capital injection into the company from his private assets in order to keep it afloat. 

“This uncertainty has overshadowed recent economic developments, like GDP growth that exceeded expectations by a mile,” Sverrisdóttir said.

Convertible bonds are often issued by companies that have speculative-grade credit ratings (in general, a red flag for investors), but high growth potential (high risk/reward). Because WOW Air operated at a loss last year, the bond issue could be a last-ditch attempt to salvage liquidity, although S&P Global, one of three major credit rating agencies, declined to comment on the economic implications of WOW Air’s flagging fortunes at this time.

The bonds are intended to carry WOW Air over the finish line until it can reach an initial public offering (IPO), at which juncture, bondholders will be able to convert them into stock in the company at a 20% discount when it registers on the stock market.

Abrupt Drop in Tourism Could Shake the Market

But that’s where the fear factor comes in. Because of WOW Air’s significant market share, the company’s reluctance to offer clarity around its bond backers and the likelihood of the IPO has raised concerns that the industry giant may come crashing down. Investment has been one of the largest drivers of GDP growth this year, and the lack of clarity might lead investors to hold off on purchasing Icelandic króna, while others might want to limit their exposure to the currency altogether.

If WOW Air were to lose traction, the tourism industry will likely go into decline along with the drop in traffic to the island unless the airline’s market share is absorbed by larger airlines, like Icelandair. The country’s transport minister has confirmed that the government is working on a plan of action should either of its major airlines get into serious trouble (jointly, 79% of air traffic).  

If tourism inflows were to abruptly decrease, it could expose the economy more broadly to vulnerabilities. It would, for example, weaken the housing market because of indirect effects on household buying power and banks’ balance sheets.

…Or Lead to Large-Scale Emigration

“If tourism takes a hit it will, of course, greatly affect the economy because it’s the biggest industry. It’s difficult to quantify the effects, for example on unemployment, because the labour market is fairly flexible. For example, the labour demand of the tourist industry has largely been met with imported labour. If the sector takes a hit, many will probably leave the country, as we saw in the 2008 recession,” Sverrisdóttir added.

National airport operator Isavia’s tourist arrival forecast, published in late May, attracted considerable attention because traffic growth projections were lowered to 2.6% from 11%, which could certainly make potential investors nervous when it comes to investing in the domestic companies in a turbulent economy.

Growth to Moderate in the Long-Term

“The growth rates in the past weren’t sustainable in the long-term and would eventually have led to overheating of the economy,” according to Sverrisdóttir. Reports on the domestic economy from S&P Global have indicated the same: the cooling off period is a necessary part of a healthy economy, and Iceland has the infrastructure to absorb shocks.

But GDP growth during the half of 2018 was much stronger than financial analysts at Arion Banki anticipated—a whopping 6.6% in the first quarter of the year—meaning that it’s likely that the GDP growth in 2018 will be somewhat higher than initially forecast, though still moderate.

However, the country—and its visitors—wait with bated breath to hear the outcome of WOW Air’s efforts to secure funding, which may ultimately determine the shape of the future.